I was near one of these legal/compensation structures many years ago. It didn't work out, so I never reaped $1 of gross benefit from it, nevermind any tax benefits.

That said, I spent the first several weeks asking "is this legal?" The management participants have zero or negligible capital at risk yet due to the legal structure receive capital gains treatment. I suppose one could argue that their "investment" is just receiving outsized returns but that is a mighty thin fig leaf. They can go further and have the fund management company issue a non-recourse loan to the management employees to "invest" in the fund, but it's all just so much left-pocket/right-pocket nonsense. The managers real world risk remains quite modest.

For all practical purposes, the managers share in the "upside" of investments but have negligible exposure to the downside. That makes it income and not the result of at-risk gains in my book. At the very least, any gains beyond the managers pro-rata share of the capital invested (and therefore the capital gains achieved) should be taxed as ordinary income. If my megacorp came up with a structure whereby I put $1 in a fund that invested solely in megacorp stock while they put in $100 and then we split the upside 20/80 the IRS would call the resulting gains ordinary income in a heartbeat.

We have strong rules elsewhere in the code that link treatment to risk. For example a non-qualified deferred comp program allows large deferrals because the assets must remain at risk of a company bankruptcy whereas a 401k is more limited in scope but is also moved beyond the reach of company creditors.

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If the carried interest is the only compensation for "doing their job", then I think there is a fair argument that they've risked their entire salary on the investment and thus carried interest kinda makes sense. If it's treated as a "bonus" for doing well (i.e. they get paid XYZ but then also get the carried interest if they perform well in their job of making the investment show gains), then I think it should be taxed like any other bonus.

Most stock options given to ordinary employees are similar to the carried interest thing, except they are taxed at ordinary income.

A) You put very little if any money in

B) You don't lose if the company and options perform poorly

C) You gain if the company and options/stock do well

I wonder why stock option grant gains are not taxed like carried interest, at a cap gains rate?

Actually, this is a good point. In Canada employee option gains are taxed at the same low rate as cap gains. However, in recent elections and budgets there has been a lot of discussion of eliminating this benefit. I would guess it will soon be gone.

Most stock options given to ordinary employees are similar to the carried interest thing, except they are taxed at ordinary income.

A) You put very little if any money in

B) You don't lose if the company and options perform poorly

C) You gain if the company and options/stock do well

I wonder why stock option grant gains are not taxed like carried interest, at a cap gains rate?

And that is part of my point of the lack of symmetry between the way carried interest is treated as preferenced income and most other forms of variable compensation are ordinary income. While I agree there are powerful powers to leave the current taxation scheme in place, I would like to see it changed.

Most stock options given to ordinary employees are similar to the carried interest thing, except they are taxed at ordinary income.

A) You put very little if any money in

B) You don't lose if the company and options perform poorly

C) You gain if the company and options/stock do well

I wonder why stock option grant gains are not taxed like carried interest, at a cap gains rate?

My megacorp stock was very volatile and cyclical; when I was issued stock options I actually purchased the shares when they matured. I waited until the stock was at or close to the option price, and I exercised them. If they were exercised above the option price then it was taxed at regular income tax rates and SSI taves. Since I now owned the stock, when the price was right, I sold the shares, and paid the cap gains tax. I did this over 20 times, and was very tax efficient.

My megacorp stock was very volatile and cyclical; when I was issued stock options I actually purchased the shares when they matured. I waited until the stock was at or close to the option price, and I exercised them. If they were exercised above the option price then it was taxed at regular income tax rates and SSI taves. Since I now owned the stock, when the price was right, I sold the shares, and paid the cap gains tax. I did this over 20 times, and was very tax efficient.

So essentially you were using your own money to gamble with the stock price of your company? I am not sure how this relates at all to what I posted, but cool story.

Most stock options given to ordinary employees are similar to the carried interest thing, except they are taxed at ordinary income.

A) You put very little if any money in

B) You don't lose if the company and options perform poorly

C) You gain if the company and options/stock do well

I wonder why stock option grant gains are not taxed like carried interest, at a cap gains rate?

I don't know for sure, but weren't stock option grants considered an "expense" on the corporate income statement for tax purposes? (if they still aren't treated as an expense) If so, then whatever is considered an "expense" should be considered "income" to the other side of the transaction (i.e. the employee receiving the stock options) to keep it "revenue neutral".

It's hard for me to justify different tax treatment on the same activity (managing other people's money) depending on whether the manager is described as an insurance company investment officer or a hedge fund manager.

Of course, whenever the law gives different treatment to certain types of income than others, I expect we will see lawyers and accountants inventing creative ways of reclassifying that income from one bucket into the other. This happens in lots of ways other than just carried interest (though CI is a big deal for some extremely well compensated people).

I'd prefer that we just tax all income at the same rate. I don't think Congress is smart enough to say that the regular market incentives for working vs. investing are "wrong" and they need to be adjusted by differential tax rates.

Really feel kind of stupid that I had never heard of this before the past Sunday presidential debate. After googling and gaining some understanding of the concept/tax loophole I am simply amazed at how the tax code favors those in the upper brackets.

+1

I also researched CI after the second Pres Debate. The best link I found was Wikipedia (below), with this enlightening excerpt.

The origin of carried interest can be traced to the 16th century, when European ships were crossing to Asia and the Americas. The captain of the ship would take a 20% share of the profit from the carried goods, to pay for the transport and the risk of sailing over oceans.

Carried Interest being taxed as Cap Gains is absurd. Just another tax preference given to a powerful lobbying group.
However, it really is minimal impact. It clearly is a sign of unfairness in the tax code, but changing the taxation to ordinary income will raise only a few dollars in revenue.
It's a great populist talking point during election cycles, but will never be dropped from the code unless there is comprehensive tax reform as too many political donations come from the tiny percentage of taxpayers that benefit from it.
Just sayin'

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